The Art of Selling

As with all markets—from grocery stores to restaurants to tire shops—there a plenty of buying opportunities out there for consumers. The same holds true for investors: the trick isn't buying so much as selling, notes John Reese of Validea Hot List.

While a lot of strategies out there tell you how to buy stocks that will make nice gains, there are few that address the second half of the stock investing equation: when to sell—the proverbial brakes on our car. It's amazing, really, because for many investors, deciding when to sell is a harder decision than deciding what to buy.

Cabot Research, a behavioral finance consulting firm, has found that even top-performing mutual fund managers may be missing out on 100 to 200 basis points per year because of poor sell decisions, Institutional Investor's Amy Feldman noted in a June 13, 2008 article entitled "Know When to Fold 'Em."

Seeing as how amateur investors tend to do much worse than the pros...it's likely that the average, nonprofessional investor suffers even greater losses because of poor sell decisions.

Part of the reason investors struggle with selling is that advice on the topic is somewhat lacking in the investment world. A survey performed by Cabot and the CFA Institute found that more than 70% of professional investors used a selling approach that was not highly disciplined or driven by research and objective criteria, Feldman noted in her piece. So it seems most of the pros aren't offering a whole lot of guidance here.

But another part of why sell decisions are so hard involves an old, familiar foe: our own brains. Just as our brains tell us to avoid unpopular stocks and jump on hot stocks when we're buying, they also cause havoc when we're trying to figure out when we should sell a stock. If you've ever put money into the market, you've almost surely found this out the hard way.

A few phenomena make selling and sticking to a selling plan a difficult task. For starters, there's the "fear of regret." When we make an error in judgment, we feel bad; often, we'll beat ourselves up with "woulda-coulda-shoulda" thinking, which is never pleasant.

And that's certainly true when we take a loss on a stock. Hindsight is always 20/20, and we end up thinking that we could have easily avoided what turned out to be a bad move. Because of the unpleasantness of those feelings, one theory on why people sell at the wrong time is that they avoid selling stocks that have lost value, instinctively wanting to postpone those feelings of pain and regret, even if those stocks now have little prospect of rebounding.

This is similar to the concept of "myopic loss aversion." In his 1999 paper, "The End of Behavioral Finance," Professor Richard H. Thaler of the Chicago University explains that loss aversion refers to the observed tendency for decision makers to weigh losses more heavily than gains—losses hurt roughly twice as much as gains feel good. Locking in losses thus hurts a lot, so we'll avoid selling stocks for a loss even after they no longer have good prospects to delay that hurt.

Why are losses so painful? The fact that they are a shot to our egos seems to be part of the reason. Professors Kent Daniel and Sheridan Titman state that people tend to ignore or underweight information that lowers their self-esteem in "Market Efficiency in an Irrational World," which appeared in the 1999 volume of the Financial Analyst Journal.

"For example," they write, "investors may be reluctant to sell their losers because it requires that they admit to making a mistake, which could lead to a loss in confidence and have deleterious consequences. For similar reasons, investors may systematically overweight information that tends to support their earlier decisions and to filter out information that suggests the earlier decisions were mistakes."

Essentially, we'll twist the facts to avoid admitting mistakes so that we feel better about ourselves and our stock-picking abilities. That keeps us from feeling bad about ourselves, but it also keeps us from learning from those mistakes.

Another common mistake many investors make is holding on to winners too long. In his 2001 book Navigate the Noise: Investing in the New Age of Media and Hype, Richard Bernstein notes that growth fund managers often do just that because they are encouraged to do so by all the good news regarding companies' prospects.

A perfect example would seem to be the tech stock boom of the late 1990s. Blinded by the hype, most of those people who had made huge sums of money ignored logic and held on to their stocks too long, only to see them come crashing down.

Nobody's Perfect
Another thing to keep in mind when it comes to selling stocks is that no investor, not even the greatest investors in the world, are right all the time. Remember what Martin Zweig says: "In the long run, a 60% success rate translates into huge gains, a 50% rate into solid gains, and even a 40% rate can beat the market."

When it comes to the stock market, no one is right all the time or even nearly all the time. Even the great Warren Buffett makes bad investments. Just read Berkshire Hathaway's annual report, and Buffett will often speak candidly about where he's gone wrong.

While you'll never be right all the time, you can be right more than you're wrong, however. In the end, the key is to develop a fundamental-based selling and rebalancing plan and stick with it, no matter what.

When your portfolio does lose ground from time to time, you'll inevitably feel the urge to sell certain stocks and go after others on a whim or a hunch to make up ground. But if you have a detailed, quantitative selling system in place, you can help keep short-term emotions from wreaking havoc with your long-term performance.